What is a Term Structure and What Can it Tell Us?

What is a Term Structure and What Can it Tell Us?

Analyzing the term structures for VIX, energies, interest rates, grains and other products provide significant insight into general and product specific market conditions, traders, investors and speculators’ expectations and trade ideas.  Term structure can be thought of as a graphical representation of the relationship between expiration and price for any instrument.  For example, here’s what the oil futures (/CL) term structure looks like if we plot the current futures price by expiration:

You’ll notice that the curve is downward sloping; prices are higher for near term contracts relative to longer-term contracts reflecting the current crisis.  A downward sloping curve is called backwardation; an upward sloping curve is called contango.  The shape of the term structure and changes in that term structure over time provide considerable market information as well as trade ideas. Let’s look at the term structure for few instruments and see where it leads us.

What is the VIX Term Structure Indicating

The VIX term structure is the relationship between volatility (as measured by the VIX) and time.  The VIX term structure is normally upward sloping; there is less risk in the short term and the further out you go in time, the greater the risk of a significant market move so the higher the VIX.  The VIX in contango is generally indicative of a bullish tone to the markets.  Notice the upward sloping VIX term structure from about a month ago indicating the market wasn’t expecting much short-term stress or risk:

Now look at the current term structure:

Notice that it is downward sloping, indicating short term risk and fear in the markets.  Traders, investors, and speculators are buying shorter term puts for protection driving up volatility. There are a few actions that this condition suggests: make sure you’re hedged, trade in smaller size recognizing the increased risk and increase options premium and use the Masters In Trading VIX Trading System to monitor the VIX term structure and watch for the extremely reliable buy signal.

What Is The Oil Term Structure Indicating

We showed the current oil term structure above.  The shape of the oil term structure is determined by several factors:  supply and demand, storage levels and costs, interest rates, marginal production costs, foreign exchange rates, geopolitical risks, and market expectations.  Here’s how the term structure has changed over the last year:

The impact of geopolitical risks is very evident by the increases in shorter term prices and the downward slope of the term structure.  Elevated risks in the oil market creates opportunities for very experienced traders.  For example, if a trader has a view that eventually the term structure will flatten or even return to contango, a trader could create a relative value trade by selling shorter term futures and buying longer term futures expecting the longer-term futures to gain in value relative to the shorter-term position.  This is not a trade for weak stomachs as evidenced by oil trading negative during the COVID crisis.  If you really want to play but with defined risk buy a short term put and a long term call on an oil related instrument.  You can’t lose more than you pay for option premiums, but given the elevated volatility, without enough movement, you could lose on both options.

What Is the Eurodollar Term Structure Indicating

Eurodollars are U.S. dollar denominated deposits at foreign banks or overseas branches of U.S. banks.  They are not subject to U.S. regulations or reserve requirements.  There is a very active, liquid market for deposits and loans based in Eurodollars.  Eurodollar futures (/GE) are used by depositors, borrowers, traders, investors, and speculators to manage or take interest rate risk.  For example, if a company knows that it’s going to borrow $10 million in 6 months to invest in an overseas project and is worried about interest rates increasing, it can lock in a borrowing rate today using Eurodollar futures.   The interest rate associated with the futures is equal to 1.00 minus the futures price; so the lower the price, the higher the interest rate.  Here’s how the Eurodollar term structure has changed over the last year:

Two significant things to note.  First, the current curve is lower than the earlier curves indicating an upward movement in rates (remember, rates are 1.00 minus the price, so the lower the price, the higher the rates) in anticipation of the Federal Reserve raising rates.  Second, the current extended curve is flat or even inverted for certain time periods.  A flat to inverted curve is associated with economic slowdowns and/or recessions.  This indicates an opportunity to protect your portfolio and possibly avoid or reduce exposure to those stocks that are particularly negatively correlated (rates go up, the stock goes down) with interest rates such as technology stocks.

Monitor and Paper Trade

You can see why it’s important to constantly monitor these three term structures; they can really help put your trades and investments in an overall market context.  Explore and analyze other term structures for energies, agricultural products, interest rates, etc.  If you’re not comfortable taking on risk, paper trade (especially with the oil trade).  Paper trading will increase your knowledge, add to your memory bank and may be the extra push you need to consistently monitor and gain perspective from these term structures.

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